The genesis of this invention originates in a need to respond to new accounting rules for Other Postretirement Employee Benefits (OPEBs). Until recently, the principal method of accounting for OPEB expenses has been the pay-as-you-go method of accounting. Under the pay-as-you-go accounting method, a corporation only recognizes those costs that it actually pays in cash. Not until 1993 have corporations been required to accrue for OPEB costs to be paid their employees in the future.
In December of 1990, the Financial Accounting Standards Board (FASB) issued accounting standard Statement 106 relating to accounting for OPEB costs--costs that primarily include retiree health care and retiree life insurance benefits. Very briefly, Statement 106 requires "calendar year" corporations reporting under Generally Accepted Accounting Principles (GAAP) to use an accrual method of accounting for OPEBs by 1993.
This change in accounting rules has a significant impact on any company with OPEB liabilities. First, the change means that corporations are required to show on their balance sheets the present value of the expected future cost of paying for retiree health care benefits promised to employees and retirees. The accounting standard requires companies to project this value taking into account anticipated medical inflation rates. With medical cost inflation racing ahead of general inflation, for many companies this liability is significant. The amount may equal a sizeable portion of their book net worth and total in the billions of dollars. For example, in 1991 IBM announced that its liability for these costs would be in excess of $2 billion. In the same year General Motors Corporation announced that its liability would exceed $16 billion.
The new accounting standard requires corporations to accrue this expense during the working life of the employee, rather than record it upon retirement or as an expense as it is paid. This has the effect of moving a future expense into the present. For most companies the impact of the new accounting standard is to create an annual book expense equal to three to six times the current pay-as-you-go costs.
Under Statement 106, a corporation may use assets contributed to a trust (or other vehicle that adequately "segregates and restricts" the use of the assets) as an offset to the accrued OPEB liability to be recorded on a company's balance sheet. Assets eligible to offset OPEB liabilities are labelled as "plan assets". Furthermore, the new accounting standard will permit recognition of the growth in "plan assets" as an offset to the accrual expense charge for OPEBs.
In prefunding for OPEBs, the U.S. tax rules are more restrictive than those that apply to qualified pension trusts. Of the alternative trust vehicles, to date corporations have primarily considered three choices: 401(h) accounts, collectively-bargained Voluntary Employees' Beneficiary Association (VEBA) trusts, and non-collectively-bargained VEBA trusts. A 401(h) account is an account held in a tax-qualified pension trust. The 401(h) account holds assets for retiree health and life benefits. Both types of VEBAs are organized as trusts qualifying under Internal Revenue Code Section 501(c)(9).
Unfortunately, most corporations can take only limited advantage of 401(h) accounts. Under current IRS regulations, 25% or less of each year's pension contribution may be earmarked for a 401(h) account. Corporations whose pensions are already adequately funded or are over-funded, usually make little or no yearly pension contributions. As a consequence, there is little opportunity for them to place funds in a 401(h) account. Because the strong stock-market of the 1980's caused many pension funds to become fully or even over-funded, this limitation is now widespread.
The current uncertainty surrounding health care financing reform in the U.S. has limited the appeal of both collectively bargained and non-union VEBAs. When a corporation receives a tax deduction for prefunding in a VEBA, any future reversion of the assets to the corporate grantor will result in a 100% penalty tax. Therefore, the return of funds to a corporate grantor makes no sense. Corporations that consider using VEBAs are concerned that if the U.S. government in some way assumes responsibility for health care, they would not be able to retrieve the investments they had made to pre-fund their OPEB liabilities.
One of the initial attractions of a VEBA is that contributions to the trust may be tax deductible. For non-union VEBAs, the tax law requires a computation of a Qualified Asset Account Limit (QAAL) and an actuarial certification of the QAAL computation. Unfortunately for some corporations, the expense and complexity of preparing QAAL computations proves to be reason enough not to implement a VEBA funding program.
In addition, the Internal Revenue Service (IRS) has recently created a task force that has been assigned to examine the computations of the QAAL for existing VEBAs. Because there are currently no regulatory guidelines on how to compute the QAAL, corporations that use a QAAL when funding a VEBA are automatically exposed to the risk of an IRS challenge. This potential for IRS controversy further limits the attractiveness of VEBAs.
In January 1993 the Emerging Issues Task Force of FASB issued a memorandum which designated assets in spendthrift trusts as qualifying for "plan asset" status under Statement 106. Heretofore, the staff of the FASB had consistently taken the position that a grantor trust was not eligible to hold "plan assets" for GAAP purposes.
A spendthrift trust is normally a grantor trust. Thus, the Emerging Issues Task Force decision has signalled the FASB's willingness to consider and accept new and innovative funding programs, so long as the funding plan adequately "segregates and restricts" the use of plan assets for the intended purpose.
Paradoxically, there are numerous potential legal "pitfalls" which arise with the use of a grantor trust. The Department of Labor (DOL) is believed likely to view any GAAP approved funding plan as a "Welfare Benefit Plan" for purposes of the 1974 Employee Retirement Income Security Act (ERISA). In turn, the IRS is believed likely to rule that any trust designated by the DOL as a "Welfare Benefit Plan" is a "Welfare Benefit Fund" for tax purposes too. In turn, the IRS designation as a "Welfare Benefit Fund" will expose the trust to the 100% penalty tax on any reversion of plan assets to the corporate grantor.
Prior to the present invention, a solution has not been discovered which permits a corporation the same funding flexibility that is available under a spendthrift trust without incurring the disadvantage of exposure to tax penalties on reversion of assets to the corporation from the plan.
Of course, computer support for the yet undiscovered solution did not exist either. Instead, the focus has been on sources for the computation of Statement 106 expense and liability forecasts. Even as the accounting rules were being debated by the FASB from 1989 through 1990, major actuarial firms and outside actuarial software vendors created systems to project book accrual expenses and liabilities. With the issuance of Statement 106 in December 1990, all these organizations quickly amended their software to accommodate the new accounting rules.
Prior to the present invention, computer systems existed that compared the cash values of life insurance to a simple arithmetic present value of the OPEBs. Systems also existed that reflected the earnings effect of prefunding with Trust Owned Life Insurance (TOLI) under a pay-as-you-go accounting environment and under the accrual accounting required by Statement 106.
For reasons outlined above, it would be highly desirable to find a method of prefunding for OPEB liabilities that overcomes the various limitations and risks associated with 401(h) accounts, VEBA trusts, and spendthrift trusts. It would also be highly desirable to develop a computer system to perform the complex calculations that would allow a corporation to estimate the economic and financial accounting impact of prefunding with the new method.
However, prior to the present invention, no known system has been able to take into account a large number of input variables generally available from a large number of different providers, including projections of insurance values from insurance carriers, corporate retiree health care cost projections from corporations, corporate tax data, corporate investment assumption data, and other corporate data. Also, no known system has been able to compute the corporate earnings and balance sheet implications of prefunding assuming accrual accounting under Statement 106, as well as after-tax cash flows and rates of returns afforded by the investment in plan assets.
With FASB Statement 106 forcing the determination and disclosure of the amount of each corporation's OPEB obligations, responsible managements facing material liabilities have therefore looked unsuccessfully for effective ways to fund. Unfortunately no simple pension-like process for tax-advantaged funding has existed. As a result, virtually every corporation across the nation (other than corporations where benefit commitments and recovery of benefit costs may be subject to regulatory review) have instituted studies to find ways to significantly reduce costs of benefits or even to eliminate them, particularly retiree health care. The present invention makes available for the first time a simple, effective means for tax exempt funding qualified for offset of OPEB and other similar FASB mandated accruals. Since many employers may find use of this invention for funding a preferred alternative to reducing benefits, this invention is clearly in the national interest.